The federal government should heed the warnings of senior officials that the economy is hitting capacity constraints by halting its multibillion-dollar fiscal stimulus spending, Reserve Bank of Australia board member
Warwick McKibbin
said.

The advice from one of the country’s leading economists follows comments by RBA governor
Glenn Stevens
and Treasury secretary
Ken Henry
that the economy is rapidly approaching its speed limit. RBA minutes yesterday confirmed this meant interest rates would have to rise above their current normal setting.

Professor McKibbin told The Australian Financial Review yesterday that the fiscal stimulus was designed for an economy that was forecast to be weak, so “it obviously needs to be ­reassessed".

“The forecasts at the beginning of 2009 were clearly different. So therefore clearly the policy should be changed," he said. “I think there is a very strong case for examining the options to scale it back."

Treasury analysis submitted to a Senate committee last year shows there is still $31 billion out of the total $87 billion fiscal stimulus package due to be spent in 2010-11 and 2011-12, mainly on infrastructure.

This excludes delays in projects from earlier years that were later identified by government auditors.

The government’s $16.2 billion school buildings program had spent only $6.7 billion by June, the latest report by the head of the government’s inquiry into the Building the Education Revolution, investment banker Brad Orgill, showed.

Treasurer
Wayne Swan
and some market economists have argued the fiscal stimulus has already peaked, is gradually unwinding and detracting from economic growth.

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But Professor McKibbin said this assessment was simplistic. “Even though it’s subtracting from the growth rate, it’s still having a positive impact on levels [of spending]," he said. “There is still a lot of spending in the system. It was a policy that was designed for an economy that was nowhere near capacity.

“So if it was the right policy two years ago for now, it obviously needs to be reassessed."

In May last year, the federal budget forecast unemployment would peak at 8.5 per cent and headline inflation to dip to 1.5 per cent in 2010-11. Treasury’s latest forecasts, published in July, predict the unemployment rate will fall below 5 per cent and the consumer price index to hit 2.75 per cent, just within the RBA’s inflation target range.

Outlook Economics director Peter Downes said the stimulus was gradually being unwound but “fiscal policy was a little bit too loose for this stage of the cycle and putting pressure on interest rates and the exchange rate".

“Ideally, fiscal policy would have been a bit tighter by now," he said. “That’s the thing about infrastructure spending – it’s hard to get going then hard to change your plans once you’ve put the plans into place."

Macquarie Group senior economist Brian Redican said fiscal policy was contracting and the schools building program should continue as private non-residential building activity was still weak.

JPMorgan economist Helen Kevans said the RBA was concerned about capacity constraints fuelling inflation and the government’s investment in infrastructure would help ease the bottlenecks.

Royal Bank of Scotland chief economist Kieran Davies said that as long as the government stuck to its plan to move the budget back to surplus by 2013, the current fiscal settings were not a problem.

The government has imposed a 2 per cent annual cap on real spending growth and promised to bank windfall revenue receipts.

A Treasury paper published last week found borrowing by the federal government had only a minor effect on interest rates.